As the workforce
becomes more mobile, many non-U.S. citizens who
become U.S. residents for work reasons have to
deal with not only cultural adjustments but also
the unanticipated workings of the passive foreign
investment company (PFIC) tax regime.

For example, U.K. citizens may have
investments in U.K. unit trusts, which for U.K.
tax purposes are very similar to U.S. mutual
funds. But as soon as they attain resident alien
status in the United States and become subject
to the full extent of U.S. tax laws, these funds
become subject to the PFIC tax regime. However,
these individuals often have no idea that they
have fallen afoul of the PFIC tax regime—that
is, until they sell their U.K. unit trust shares
and think they have a capital gain taxable at a
top long-term rate of 15%.

Then
their tax adviser has to break the news that they
have been ensnared by the PFIC rules. The gain on
the sale of the shares is treated as an excess
distribution under Sec. 1291(a)(2) and is taxed
under the rules for excess distributions in Sec.
1291(a)(1). This item examines what this means and
how the sale of U.K. unit trust shares or other
PFIC stock is taxed for U.S. tax purposes.

Example
1:B, who is a
U.K. citizen, bought 100 shares of a U.K. unit
trust on Jan. 1, 2006. He became a U.S. resident
alien on July 1, 2009, and sold the shares on
April 30, 2012. His total holding period is 2,311
days. The 100 shares cost £10 each, and he sold
them for £20 each. What are the U.S. tax
consequences of the sale?

The issues to
consider are:

Can B step up the
basis in his stock to fair market value (FMV) as
of the date he became a U.S. resident alien,
which would then become its cost basis? No. Rev.
Rul. 55-62 provides that no step-up in basis is
permitted to the FMV of the asset as of the date
that U.S. residency starts. The revenue ruling
provides that the taxpayer is taxable on both
pre-residency and post-residency gain in the
United States when a taxable event occurs, e.g.,
a sale or exchange.

At what exchange rate is the original cost
of the shares translated? For U.S. tax
purposes, the exchange rate on the date of
purchase is used (see Rev. Ruls. 54-105 and
78-281), i.e., $1.7234:£1 (midpoint rate on
Jan. 1, 2006, per this online translator). So B’s 100 shares cost $1,723.

At what exchange rate is the sale price of
the shares translated? As with the cost part of
the calculation, the exchange rate on the date
of the disposal is used, i.e., $1.6259:£1. So
B’s
100 shares were disposed of for $3,252 (100
shares × £20 × 1.6259).

Therefore, the total gain on the sale of B’s 100 shares
in the U.K. unit trust is $1,529.

Now the
question becomes whether all this gain is taxed as
an excess distribution as if the unit trust shares
were PFIC stock from the date of acquisition.
Under the excess distribution rules, once the
excess distribution gain has been determined, it
is allocated ratably to all the days in the
investor’s holding period, in this case, Jan. 1,
2006, to April 30, 2012. However, this can result
in an allocation to three distinct periods: (1)
the pre-PFIC period—the period that the investor
held the stock before it became a PFIC stock; (2)
the current-year period—the days in the investor’s
tax year when the excess distribution occurred,
i.e., Jan. 1, 2012, to April 30, 2012; and (3) the
prior-year PFIC period—the days in the investor’s
prior tax periods during which the foreign
corporation was a PFIC.

So the issue then
becomes how to split the excess distribution gain
among these three periods. Based on the fact that
B’s
unit trust shares under U.S. law would have been
PFIC shares from the date of acquisition, it would
appear that all the PFIC gain, except for the
amount allocated to 2012, would be prior-year PFIC
period and subject to the highest rate of tax and
an interest charge for each year the gain is
allocated.

However, Regs. Sec. 1.1291-9(j)(1)
provides that

a corporation will not be treated as a PFIC
with respect to a shareholder for those days
included in the shareholder’s holding period
when the shareholder . . . was not a United
States person within the meaning of section
7701(a)(30).

Since B did not
become a U.S. resident until July 1, 2009, the
excess distribution gain allocated to Jan. 1,
2006, to June 30, 2009, is pre-PFIC period, and
the gain allocated to July 1, 2009, to Dec. 31,
2011, is prior-year PFIC period.

So how is
the gain taxed? Per Sec. 1291(a)(1) and Prop.
Regs. Sec. 1.1291-2(e)(2):

The pre-PFIC period gain—$845 ($1,529 ×
[1,277 ÷ 2,311 days])—and current-year
period gain—$80 ($1,529 × [121 ÷ 2,311
days])—are taxed as ordinary income on B’s 2012 U.S. tax return. Even though B’s stock may have otherwise qualified for
the 15% dividend tax rate, the stock is a PFIC
security that is not eligible for the 15%
rate. Therefore, this income is taxed at
whatever B’s marginal tax rate is for 2012.

The prior-year PFIC period gain—$604
($1,529 × [914 ÷ 2,311 days])—is further
allocated to the specific tax year in which it
was deemed earned, i.e., 2009—$122; 2010—$241;
and 2011—$241. B is then
subjected to the highest rate of tax on these
gains, irrespective of his actual marginal rate
of tax during that year. Once the tax has been
determined, it is subject to an interest charge.

In summary, B was unaware
of the PFIC rules, so what he thought was a
capital gain subject to 15% federal tax resulted
in a much greater tax burden. This is normally a
big shock to non-U.S. citizens holding PFIC stock
who become U.S. resident aliens subject to U.S.
income taxes on worldwide income. A practitioner
who advises a taxpayer before he or she becomes a
U.S. resident can warn of the PFIC pitfalls and
help the taxpayer plan accordingly. The taxpayer
may decide to sell the PFIC stock before becoming
a U.S. resident and invest in a vehicle that is
not subject to these rules and thus mitigate the
U.S. tax burden.

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